1. Horizontal Boundaries of the Firm: Economies of Scale and Scope Chapter 2

2. Economies of Scale and Scope Economies of Scale The concept of economies of scale provides the primary connection between technology and firm competitive strategy Numerous definitions, but the most useful seems to be: Economies of scale exist when average cost is declining . Important to distinguish between long-run and short-run notions of economies of scale.

3. Long-run : shape of the average cost curves dictated by existing state of knowledge. $ Q Minimum Efficient Scale

4. Short-run: technology (quasi-) fixed and embodied in plant and capital investment (e.g. business design) $ Q Minimum Efficient Scale

5. Long-run economies of scale impact industry structure and are only relevant in the pre-entry stage. Short-run economies of scale, affect operating decisions and are relevant to post-entry stage

6. In essence, joint production is less costly than production of single product lines Economies of Scope Economies of scope exist when there are cost savings associated with a broadening of a firm’s scope of activities. Increases in the number of products or services produced Formally, economies of scope exist if: C( Y 1 ,Y 2 ) < C( Y 1 ,0 ) + C( 0,Y 2 )

7. An example of Economies of Scope Costs of Print Message Notes and Tape Q x Q y TC(Q x , Q y ) 100m 0 $55m 0 600m $220m 100m 600m $245m 200m 0 $60m 0 1200m $340m 200m 1200m $370m

8. Sources of Economies of Scale and Scope Indivisibilities and fixed-cost spreading specialization (increased productivity of variable inputs) Inventories The cube-square rule

9. Indivisibilities and Fixed-Cost Spreading Spreading of product-specific costs Trade-offs among alternative technologies Indivisibilities more likely with capital intensive technology The division of labor is limited by the extent of the market

10. Costs of Producing Aluminum Cans 500 million cans per year 125 million cans per year Fully Automated Average fixed costs = .01 Average fixed costs = .04 Average labor costs = .00 Average labor costs = .00 Average materials costs = .03 Average materials costs = .03 Average total costs = .04 Average total costs = .07 Partially Automated Average fixed costs = .0025 Average fixed costs = .01 Average labor costs = .01 Average labor costs = .01 Average materials costs = .03 Average materials costs = .03 Average total costs = .0425 Average total costs = .05

11. Scale Advantage and Capacity Utilization $ Q SAC 1 SAC 2

12. Can convey technical economies in distribution and storage Specialization Efficiency gains via specialization of function? Organizational efficiencies Inventory Management Cost of inventory management can decline with size of firm Smaller inventory as a percentage of total sales Cube Square Rule (2A 3 ) Ratio of surface area to volume declines geometrically

13. Other Sources of Scale Spreading of marketing and advertising costs Reputation effects Research and development costs Purchasing economies Complementarities and Strategic Fit

14. Mobilizing assets Sources of Economies of Scope Utilization of excess capacity (especially in the presence of indivisibilities) Utilization of fixed marketing/retailing costs/infrastructure Exploitation of reputation and brand identity Common terms used in (implicitly) discussing economies of scope include: Leveraging core competencies Competing on capabilities

15. Spreading of Specialized Resources Sources of Diseconomies of Scale Labor Costs and Firm Size Incentive and Bureaucracy costs Conflicting Out

16. Efficient pricing or competition policies Learning Curves Learning Curves account for the cost advantages associated with experience and know-how Can occur at the individual level Can occur at the organizational level Learning curve advantages can be manifest in: Lower costs Higher quality

17. Learning Curve $ Cumulative Production AC AC 2 2Q 1 AC 1 Q 1

18. Measures the decline in average cost when cumulative output is doubled. Progress Ratio PR = AC 1 /AC 2 Median for U.S. is about 0.80, which implies a reduction in unit cost of 20% for each doubling of cumulative output.

19. $ Q AC 1 (Q 1 ) AC 2 (2Q 1 )